Illinois Back in Crisis as Tax Impasse Risks Rating: Muni Credit

May 29 (Bloomberg) -- Another May legislative session in
Illinois, another financial crisis.

Lawmakers are shunning Democratic Governor Pat Quinn’s plan
to extend tax increases in effect since 2011, while also balking
at spending cuts. The impasse means the lowest-rated U.S. state
faces a $2 billion budget hole for the year beginning July 1 and
risks further bond downgrades. A house proposal relies on one-shot revenue and delayed payments, which rating companies scorn,
as a stopgap before November elections.

The partisan haggling may cost taxpayers as it dredges up
memories of the legislative session a year ago, when failure to
produce a pension fix led to two rating cuts. Investors demand
1.12 percentage points of extra yield to own 10-year state bonds
rather than AAA municipal debt, close to the highest since May
5, data compiled by Bloomberg show.

“The pattern in Illinois has been crisis management,”
said Eric Friedland, head of muni research in New York at
Schroder Investment Management North America, which oversees $4
billion in local debt. “I wouldn’t consider this a good entry
point” for the bonds as “there’s going to be more news coming
out of Illinois that may shake some investors.”

Rally Halt

Illinois has benefited from demand in the $3.7 trillion
municipal market after lawmakers in December broke through
decades of gridlock to pass a measure addressing the worst-funded state pension systems. The state’s borrowing costs
dwindled in bond sales since the pension bill.

A $250 million tax-free offering in April included 10-year
debt priced to yield 0.93 percentage point above benchmark
munis, the smallest yield spread since 2009.

The gains have halted amid the budget showdown, which
threatens the state’s finances. House Speaker Michael Madigan
said this week that the chamber lacks the votes to pass a tax
extension.

The legislature, which is controlled by Democrats, is
moving toward a 2015 budget that uses steps that have led to
bond downgrades.

The house this week approved a $35.7 billion budget for
next fiscal year. Without revenue from the extended tax
increases, the proposal relies on fund transfers, delayed
payments to vendors and forgoing paying for employee raises and
increases in health-insurance costs. The senate still has to
consider the budget.

Illinois Embarrassment

“This is embarrassing to the state of Illinois,” Dennis
Reboletti, a Republican, said on the house floor.

Senate President John Cullerton, a Chicago Democrat, said
the state is headed toward a replay of circumstances that led to
the 2011 tax boost -- lawmakers will have to return after
November elections to come up with more money to pay for the
budget, and could try to extend the higher tax rates then.

Quinn’s Republican challenger, venture capitalist Bruce
Rauner, has said the tax boost should roll back at year-end,
though he hasn’t recommended how to replace the lost revenue.

The temporary personal-income tax increase in 2011 raised
levies to 5 percent from 3 percent and was the largest in
Illinois history. The legislature passed the increase to help
close a $13 billion budget deficit. Quinn in March proposed
keeping the higher rate.

Floundering Ahead

About 46 percent of Illinois’s general-fund revenue came
from individual income taxes in fiscal 2013, according to a
report last week from Comptroller Judy Baar Topinka.

“Decisions made by today’s lawmakers could determine
whether the state can pull itself out of its current hole, or
continue to flounder,” Topinka, a Republican, said in her
report.

Moody’s Investors Service and Fitch Ratings maintain their
negative outlook on Illinois because of questions over future
revenue and the constitutionality of the pension bill. Standard
& Poor’s has a “developing” view. All three rate the state
four levels above speculative grade.

Fitch could cut the state’s rating if the budget isn’t
balanced or counts on passing a tax extension in the future,
said Karen Krop, an analyst in New York. Offsetting the lost
revenue with spending cuts wouldn’t merit a cut, she said.

Moody’s Outlier

Illinois’s rating “is already an outlier and it factors in
a lot of the pressures that are evident” in the budget battle,
said Ted Hampton, a Moody’s analyst in New York. “At this
point, it appears pretty clear that the 2011 tax rates aren’t
going to be maintained.”

Illinois has benefited from muni interest rates falling to
the lowest in almost a year, spurring a flight into riskier
debt. Bonds from the state and its localities have gained 6.5
percent this year, compared with the entire market’s 5.7 percent
advance, Barclays Plc data show.

“I wouldn’t say the market is overjoyed with what they’ve
done here in Illinois,” said Tim McGregor, head of munis in
Chicago at Northern Trust Corp., which oversees $30 billion of
munis. “A lot of the credit-spread tightening may not be for
fundamental reasons.”

The demand could evaporate if lawmakers let the tax boost
expire, said McGregor and Friedland.

“They have a political structure that is all Democrats, so
arguably they should be able to get anything passed, yet they
can’t get anything passed,” said Justin Land, who helps manage
$3 billion of munis at Naples, Florida-based Wasmer, Schroeder &
Co. “That’s the history of Illinois politics.”